Exploring Mispricing in the Term Structure of CDS Spreads

Jarrow, R, Li, H, Ye, X and Hu, M 2019, 'Exploring Mispricing in the Term Structure of CDS Spreads', Review of Finance, vol. 23, no. 1, pp. 161-198.


Document type: Journal Article
Collection: Journal Articles

Title Exploring Mispricing in the Term Structure of CDS Spreads
Author(s) Jarrow, R
Li, H
Ye, X
Hu, M
Year 2019
Journal name Review of Finance
Volume number 23
Issue number 1
Start page 161
End page 198
Total pages 38
Publisher Oxford University Press
Abstract Based on a reduced-form model of credit risk, we explore mispricing in the credit default swaps (CDS) spreads of North American companies and its economic content. Specifically, we develop a trading strategy using the model to trade out of sample market-neutral portfolios across the term structure of CDS contracts. Our empirical results show that the trading strategy exhibits abnormally large returns, confirming the existence and persistence of a mispricing. The aggregate returns of the trading strategy are positively related to the square of market-wide credit and liquidity risks, indicating that the mispricing is more pronounced when the market is more volatile. When implemented on the Markit data, the strategy shows significant economic value even after controlling for realistic transaction costs.
Subject Banking, Finance and Investment not elsewhere classified
Keyword(s) credit default swaps
mispricing
statistical arbitrage
affine models
market-neutral strategy
hedge funds
DOI - identifier 10.1093/rof/rfy014
Copyright notice © The Author(s) 2018
ISSN 1572-3097
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